On the Pernicious Myth of the Free Market

So: let’s begin the experiment in how quickly I can rebuild blog traffic after a summer’s neglect, shall we?

A week or so ago, there was a Twitter flurry on the subject of phrases some of us would like to see banned from science writing, stimulated by the annoyingly prolific Carl Zimmer‘s list of such sins. (His fault you’re a sloth? — ed.) Some very good ones there, this being my favorite (for obvious reasons):

Breakthrough (unless you are covering Principia Mathematica)

But the list of writerly shortcuts we should all avoid made me think of the phrase that gets my goat every time I hear it — which means that I am goatless a lot of the time. For that phrase is “the free market.”

I twittered my disdain for that term, noting in 140 characters or less that “free markets” as imagined do not exist in nature, and that hence, at best, they are the analogue to the physicists’ herd of spherical cows.

In fact, as friend of Inverse Square Ian Preston pointed out to me, that analogy is wrong — or at best, only a bit right. The bit that’s right is that there is a spherical-cowlike idea that economists make use of all the time. Where physicists simplify something like a shape to make a calculation or a proof-of-concept argument a little easier, economists will assume circumstances in which markets behave exactly as we were taught in our versions of Ec 10: there is perfect competition, perfect information available to all parties and so on. Such markets are spherical…goats, perhaps, just to keep the field clear for physicsts contemplating falling bovines.

What they are not is “free” markets, at least not in the sense that term is used in popular discourse. Remember: when a physicist says “consider a spherical cow” you and she know that you have just entered the realm of the imagination. When some right-radical* propagandist uses the term “free market” you also know what is being advanced: the notion that these drastic simplifications actually exist in the wild, and that any deviation from an absolutely unfettered market structure represents both a practical and a moral ill.

But, of course, there are no such creatures roaming the savannah.

Rather, as both economists and less rarified people who actually pay attention to the distortions in just about every market have recognized, all kinds of things in the real world make markets less than perfect, “unfree.” Assymetric information is one buzzword, regulatory capture is another phenomenon, various kinds of externalities apply other distortions to transactions, governments can intervene to increase or decrease the efficacy of market mechanisms…and so it goes.

The point, obvious to all but those willing themselves to believe in Adam Smith as the tooth fairy, is that his invisible hand is not placing dollars under virtuously self-interested pillows unbuffeted by all kinds of forces. Instead, the phrase “free market” is primarily propaganda, an attempt to perpetuate the big lie that there necessarily cannot be any better outcome than the one that transfers the most wealth and power to those who already have seized so much of it in the last years and decades.

That’s where Ian stepped in, both to echo my thought and to extend it (and perhaps, just a bit, to attempt to insulate his profession from the worst of what radical right hacks are trying to do in the name of modern economics). As he wrote in email he has kindly given me permission to publish…

Saw your tweet on “free markets” and completely agree but I think you’re only halfway to the truth. The real spherical cow is the “competitive market.” “Free market” strikes me as a phrase you hardly ever hear mainstream economists use in an academic context. (You do hear “free trade” but I think there’s a different political resonance to that phrase). There are plenty of reasons to link efficiency with idealised competition but “competitive markets” don’t make for such good right wing rhetoric as “free markets” and any fool can see that freeing particular markets up is often neither necessary nor sufficient for making them competitive.

Now why should you listen to Ian, even if you don’t to me? Perhaps because he is, in fact, a real economist and a very good one. As such, on being asked if he would let me disseminate his note above, he did what conscientious thinkers are supposed to do. He tested his own conclusions:

Since you’re thinking of basing a blog post on it, I thought it’d be a good idea to check that I’m not talking nonsense. I put the phrases “free market” and “competitive market” into Google Scholar, linking them to particular economic journals. The former does seem to be typically less common and particularly so the more theoretical or technical the journal to which the search is linked – see the attached table. “Free market” does appear to occur in technical phrases like “free market equilibrium,” which does have a ring of familiarity, so you can’t really say it is never used in that way but I suspect it is most often coming up in phrases like “free market policies”. There’s some evidence there anyway for my casual impression that “free market” is more often useful as rhetoric or as a description of a particular kind of policy whereas “competitive market” is the more precise and useful analytical simplification – the spherical cow, in other words.

At the bottom, in an attempt to put an upper bound on the ratio, I have added the results of a similar search linking to one of the journals associated with the non-mainstream Austrian school. I admit that I have never even looked at this journal but the results show the sort of heterodox economists who evidently do find it useful to talk about the “free market” – the sort of people who mistrust mathematical modelling, mistrust econometrics and mistrust any attempt by government to override the price mechanism.

Here’s the chart:

The moral of all this: (a) when someone uses the phrase “free market” in political discourse, hang on to your wallet. And (b) fight the con that such people are trying to run on you — us, everyone. What we need, again, as a practical matter as much as and before any moral considerations, are competitive markets, fair markets. One thing that recent experience has reaffirmed is that you can’t have a prayer of getting such at least sort-of-level playing fields (and hence, genuinely efficient allocators of capital and maximizers of desire) without explicit government regulation of market behavior.

Here this sermon endeth. Less abstract stuff to come. Happy first-day-of-school (at least for father and son in the Levenson household) to all.

*Another one of my pet peeves is the term “conservative” — which, IMHO, is in American politics a spinner’s term to describe people and views who are neither conservative in the formal sense of the term, nor connected to history in any way that resembles what traditionalists assert as the wellspring of their views. They are instead authoritarian (hence the right) and willing to do enormous damage to the polity to achieve authoritarian power — the radical part.

Do fiscally conservative economists really use “free market” in the way and to the extent that left-wing bloggers claim they do? I doubt it.

I also doubt that fiscally conservative economists rely on Adam Smith to any greater extent than evolutionary biologists rely on Charles Darwin. Or that fiscally conservative economists believe in homo economicus any more than evolutionary biologists believe in the accuracy of Haeckel’s embryos.

So what did Smith actually write?

But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavours as much as he can, both to employ his capital in the support of domestic industry, and so to direct that industry that its produce maybe of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain; and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

Italics added.

So, I suppose you could say that Smith really believed in the invisible hand, or, if you know about allegory, you could see he wasn’t talking about something real, but an effect that is real. Just like when evolutionary biologists use phrases like “nature selects for certain characteristics.” Nature does no such thing. It’s allegorical phrasing. Just like Smith’s reference to the invisible hand.

Thanks for this, and the effort that went into its writing, but I think you miss my point.

It is not Smith I criticize, nor the use of metaphor, but the failure of latter day self-professed acolytes in the church of Smith, (few of whom, I’ll wager, have read his “Moral Sentiments”) to understand either the allegorical nature of the invisible hand, nor the fact that in the real world as we’ve come to study it “free” markets are virtually passenger-pigeon rare.

(Speculating here, for a post I may research and write — I’d be interested to know the degree to which markets that begin with a fully level playing field, with what economists would be able to define as a fully competitive environment, but are subject to no external regulation, rule making, or enforcement, remain thus efficient and competitive. I’m sure there is plenty of work done here; I’m sure much of is it fraught by the expectations of the workers, but I’d still like to dive deeper into the empirical understanding of the ways in which markets fail — or rather, how they distort, and how market (and then, in a feedback loop) political power concentrates.

But what is this assy-metric of which you speak? Does it measure the credibility of speakers of the phrase free market in inverse proportion to their ass size? That would get Newt Gingrich right, though that’s only one data point.

As a gift to you (early birthday!), did you miss this sweet take-down of McMegan while you were away having fun? Where have I heard the argument from incredulity before? Hmm…

Well, yeah. Except for the antelope (of one sort or another) whose head I saw above the staircase at the Army and Navy Club in London, whose deformed horn looped around to penetrate its skull. That was a coffee cup.

“One thing that recent experience has reaffirmed is that you can’t have a prayer of getting such at least sort-of-level playing fields (and hence, genuinely efficient allocators of capital and maximizers of desire) without explicit government regulation of market behavior.”

Maybe that’s true, but I don’t think recent experience is all that clear as to how much is the right amount of regulation.

Certain markets (housing, finance, auto manufacturing) have inflicted bubbles and bailouts upon us during and after periods of large, and increasing, government intervention.

Certain other markets (tech, telecommunications, transportation) have given us lots of neat things, like cell phones and iPods and affordable flights to Vegas, during and after periods of less, or decreasing, government intervention.

No definitely more, not less. The number of provisions in the relevant titles of the CFR and US Code, and the amount spent enforcing them, tends to increase every year.

My understanding of the supposed “deregulation” argument put forward by Professor Krugman et al is that, although regulations were increasing, they weren’t increasing in a way that was fast enough or smart enough to keep up with changes in the marketplace. No one seriously claims there was literal deregulation.

There was arguably a movement among people in finance from more heavily regulated activities to activities that were less regulated under existing law, but that is not deregulation. That is just people finding holes in particularly onerous and complicated existing regulations.

In other words: areas that were heavily regulated worked fine and didn’t cause a market meltdown, while areas that were unregulated (derivatives etc…) or under regulated did cause a market meltdown and require their canny manipulators to be bailed out. So, e.g. and to wit its regulation that’s at fault? Gotcha.

“In other words: areas that were heavily regulated worked fine and didn’t cause a market meltdown, while areas that were unregulated (derivatives etc…) or under regulated did cause a market meltdown and require their canny manipulators to be bailed out. So, e.g. and to wit its regulation that’s at fault? Gotcha.”

I guess that’s one way to look at it. If you define your industry narrowly enough you can find something “under-regulated”. On the other hand I wonder whether people would even have been engaging in these transactions that you say caused the meltdown, if not for their efforts to avoid the effect of regulations. Shouldn’t a regulation be evaluated on the basis of what it actually incentivizes people to do, including pushing people out of one segment of the industry into another, riskier segment?

Also, many of the problems in the finance industry resulted from the housing bubble, and there’s no denying that housing has enjoyed massive, massive amounts of government largesse. So I would posit that there was quite a lot of government intervention in finance, even the bits of it that may have slipped through the cracks of the old regulations. Shouldn’t this be counted for purposes of evaluating, broadly speaking, how involved the government is in finance if we want to compare it to, say, tech?

I didn’t mean to be advocating a particular position so much as challenging what seem to be some unexamined assumptions. Maybe different industries, because of their different purposes and functions, require different intensity of government intervention in order to achieve their maximum possible real-world contributions to human utility. But if that’s the case then I think we should be open to the possibility that some industries may yet, even today, be over-regulated, while others may be under-regulated.

Repealing the Glass-Steagal act was a clear example of deregulation (or an example of deregulation with insufficient reregulation, if you want to make that distinction).

You’re right that law texts always seem to add a lot of cruft, but to claim there was no financial deregulation is simply flat-out wrong. Allowing the combination of securities, insurance and banking without regulating them was one of the main causes for the financial crisis (combined with the rise of highly leveraged, and again badly regulated, investment banks).

Cell phones and iPods and flights to Vegas BTW, are all very heavily regulated industries. Focusing on cell phones and flight, these are both very traditional “doesn’t work without government intervention” type markets. What would happen if there was no FCC to tell people what frequencies they are allowed to use and how? I’ll tell you what, unusable cellphones, dangerous levels of cellphone radiation and no airlines (no reserved and safe band to communicate with them over).

Which was exactly the whole point Tom was getting at. Free markets (or competitive markets) work when everybody’s self interest aligns with the public interest (the invisible hand). They don’t work when your own self interest conspires to dupe everyone into buying highly overpriced junk that will one day turn out to be worthless costing millions of people trillions of dollars while you laugh all the way to the bank (or not, depending what investment bank you worked for), i.e. mortgage backed securities.

Well my point was that travel and transportation were both deregulated significantly under Carter. So yes, they remain regulated, but much less so than they were in the early ’70s. So while granting that some level of government intervention is necessary, more government intervention is not necessarily always good.

Glass-Steagal did not exempt any securities, insurance or banking activities from the regulations applicable to such activities. I will grant that allowing all three subcategories of activities to be conducted by a single affiliated group was an instance of deregulation, in the context of generally increasing regulatory requirements applicable to such activities (for instance from Sarbanes-Oxley and the AML-type provisions of the PATRIOT Act).

It occurs to me that there is a second weakness with the blind acceptance of the dogma that free markets are always best.

As I understand it, to prove the optimality of free markets requires more than assumptions about the market and environment (Tom’s “perfect competition, perfect information available to all parties and so on”) — the proof also requires the presumption that all of the people engaged in the market are rational actors (aka “homo economicus”, as 10,000 li noted).

However, we know that humans are, at times, irrational in their economic activities. We know this both from academic research and from our own experience and observations of the world.

In particular, there exists a field known as “advertising”, in which both rational and emotional appeals are made to consumers to entice them to purchase a particular good or service. Advertising is data driven — methods that do not increase sales are generally abandoned. On the whole, emotional appeals to people are still widely used, presumably because they work.

Therefore, we know that a significant fraction of economic activity is driven by emotional, rather than rational choices. So, even within a competitive market, the real-world results can be less than ideal because we, collectively, are less than perfectly rational in our economic decisions.

(The general success of competitive markets suggests some lower bounds on how rational people are in their decisions. The existence of bubbles, fads, and crazes sets some upper bounds as well!)

The “Free market” myth is most certainly pernicious. The “rational man” myth is, IMHO, comparably pernicious, and even less visible.

Jim, I wouldn’t call the rationality assumption pernicious. Of course, I would say that, as an economist who uses it, but I think making use of it is defensible in many contexts. It’s certainly not some extraordinary collective naivety nor a desire to whitewash the workings of unregulated markets that motivates its adoption.

What the assumption amounts to is saying that we shouldn’t expect people to choose systematically to spend in ways that are more expensive than others available to them which would leave them better satisfied. That mouthful’s not always going to be true but there are many contexts in which it’s going to be sensible. What’s convenient about it is it helps capture why people substitute away from things as they become more expensive and it does so in a consistent way that also delivers a credible link to consumer welfare effects without recourse to paternalistic assumptions about what is good for people (something that I think economists are rightly averse to). In other words, rationality is an attractive basis for analysis not because it tells us everything goes swimmingly in a world without government intervention but because it lets us evaluate things like the effects of monopoly and taxes and so on intelligibly in terms of what consumer behaviour tells us about what people themselves want. Furthermore it has testable implications. Good applied economists know how far and what it is that they are assuming when they invoke rationality and they make efforts to test it, as far as they can, and they worry about the implications when it appears to breaks down.

I don’t think any sane economist would believe that people never make mistakes in economic decision making. As you say, it only takes personal observation to realise that we all do. I can see that systematic failures of consumer rationality can be cause for intervention in some markets: for example, where pricing schedules are complex, there is ill-understood uncertainty, scope for deception and so on – financial markets, especially, in other words. But in other markets there are, I would say, far more urgent issues – abuse of market power, public goods, externalities, information-based problems, weighing up the case for taxation and so on – and rationality, as defined above, may be much less troubling and the key to pulling useful information out of consumer data.

One thing that it doesn’t mean is that people can’t respond to emotional appeals or have fads in their tastes. Where else would anyone believe spending preferences came from than consumer sentiments? Sensitivity of tastes to corporate spending on advertising raises interesting issues but if that is what I were looking at it would still be natural to me to model behaviour as rational in the sense described above, conditional on whatever advertising does to tastes (and analyzing the welfare effects of advertising would take you naturally outside any competitive setting anyway).

Sorry for the rather long comment but I thought it might be worthwhile to explain why even economists unwedded to blind faith in free markets find the assumption of rationality frequently compelling.